Something very peculiar is afoot. Well after the bank regulatory reform debate was supposedly settled, central bankers seem to be reopening that discussion. It’s puzzling because the very reason the banks won so decisively was that central bankers were not prepared to get all that tough with their charges.

I’m not clear what has led central bankers to get a bit of religion. Is it the spectacle of the Bank of England talking about breaking up the banks (they won’t get their way thanks to bank lobbyist working over the Independent Banking Commission, but no one doubted their sincerity)? Or the Swiss National Bank imposing 19% capital requirements, which as we discussed, is likely to lead to the investment banking are of UBS being domiciled elsewhere (assuming a country capable of bailing it out will have it)? Or perhaps it is central bankers being forced to recognize that their Plan A of extend and pretend and super low interest rates simply won’t lead banks getting to meaningfully higher capital levels when the staff continues to take egregious amounts out in compensation? Or have they realized how bad bank balance sheets are in the Eurozone and how tight the linkages still are among the major capital markets players, and they belatedly realize they need them to be much more shock resistant?

The bottom line is that various central bankers have taken the surprising step of insisting their banks meet more stringent requirements for the biggest banks than those originally planned to be to be included in Basel III. Per Bloomberg:

The Basel Committee on Banking Supervision is considering extra capital requirements of as much as 3.5 percentage points that the largest banks may face if they grow bigger, according to two people familiar with the talks.

The so-called surcharge would take the form of a boost to capital the banks must hold and would apply to financial institutions whose collapse would harm the global economy. A list of such banks hasn’t been disclosed.

Draft plans circulated before a meeting next week would subject banks to a sliding scale depending on their size and links to other lenders, said the people, who declined to be identified because the proposals aren’t public. Banks wouldn’t initially face the highest surcharge, which is intended as a deterrent to expansion, one person said. The largest banks may face a 3 percentage point levy at their current sizes

Predictably, banks who have been conditioned to throw temper tantrums to get their way are now howling at the prospect of being asked to hold more capital. But to me, the most important element here is that being exposed to other banks, or “tightly coupled” is being discouraged. As we have discussed in other posts, following the work of the Bank of England’s Andrew Haldane, there are two approaches to companies that produce externalities, like pollution and financial crises: taxation or prohibition. Which is appropriate depends on the level of private costs versus social costs. When social costs are high relative to private costs, prohibition makes more sense. Haldane did a back of the envelope calculation that showed that taxation was grossly inadequate as a remedy (we’ve cited this quote repeatedly precisely because we think it’s critically important):

….these losses are multiples of the static costs, lying anywhere between one and
five times annual GDP. Put in money terms, that is an output loss equivalent to between $60 trillion and $200 trillion for the world economy and between £1.8 trillion and £7.4 trillion for the UK. As Nobel-prize winning physicist Richard Feynman observed, to call these numbers “astronomical” would be to do astronomy a disservice: there are only hundreds of billions of stars in the galaxy. “Economical” might be a better description.

It is clear that banks would not have deep enough pockets to foot this bill. Assuming that a crisis occurs every 20 years, the systemic levy needed to recoup these crisis costs would be in excess of $1.5 trillion per year. The total market capitalisation of the largest global banks is currently only around $1.2 trillion. Fully internalising the output costs of financial crises would risk putting banks on the same trajectory as the dinosaurs, with the levy playing the role of the meteorite.

Yves here. So a banking industry that creates global crises is negative value added from a societal standpoint. It is purely extractive. That means that taxation (and capital charges are effectively a form of taxation, in that they are meant to change the economics of the business so as to discourage certain behaviors) is an inadequate remedy and far more aggressive measures are warranted.

That view is confirmed by another way of thinking about the problem. The TBTF banks are tightly coupled, which means when Something Bad happens, problems propagate through the system so rapidly that it is well nigh impossible to interrupt the process. It’s like a badly designed electrical grid where a bolt of lightening hitting one transformer would take the entire eastern half of the US down.

In tightly coupled systems, you need to undo the tight coupling first. That’s why remedies like exchanges and clearing houses are in theory improvements, since they create contained points of failure (but in practice, the derivatives clearinghouses mandated in Dodd Frank may wind up being inadequately margined due to the unwillingness to require sufficient margin on credit default swaps since they would render the product uneconomical, and not sufficiently independent of the big banks to achieve the desired risk reduction). But the most important measure, that of breaking up the big banks and requiring firms to be more specialized (say investment banks, retail banks, and asset managers) and subject to sector-specific rules, is off the table.

If the excessive integration is not alleviated, measures intended to reduce risk typically make matters worse. This was a discussion from reader Lune on March 17, 2008. Notice how many elements of the forecast, the stresses on Fannie and Freddie becoming untenable and the mortgage market continuing to be a mess, have come to pass:

2) Fed opens TSLF to unfreeze mortgage market. Result: Carlyle goes bankrupt as people rapidly arbitrage the difference between holding MBS in firms that can and can’t access the new credit facility. Mortgage markets remain frozen.

Lune also provided a forecast that in many respects was prescient. And that was because, just as you’d expect in a tightly coupled system, the more you try to do, the worse things get.

And not only has Basel III not addressed why our financial system is so disaster prone, but it also falls short on other fronts. Our Richard Smith provided very informative write-ups (see here, here and here)

The bizarre bit here is the sudden gear shift by central bankers. Basel III was correctly criticized on a number of fronts: ridiculously attenuated phase in (the new capital rules aren’t fully in effect until 2019), preserving the concept of risk weighted assets (when as London Banker scathingly pointed out, hasn’t fared too well), and a failure to address liability side issues (particularly as relating to derivatives; they were a major culprit in why Lehman’s leak turned out to instead be a black hole). This is Richard Smith’s drive-by shooting:

Here are my main gripes:

Valuation: the capital ratios mean nothing if the assets are overvalued. Waldman is always going on about this. It ends up as quite a radical critique: capital ratios without valuation reform = cart before horse.

Accounting: there is still no harmonization of accounting practices on all the shadow banking apparatus: for instance, special purpose vehicles, derivative netting and repos. Actually, of course, when you come across things like Repo 105, or BoA’s quarter end balance sheet manipulations, there don’t seem to be any relevant reputable accounting practices at all; even if you think Lehman’s liquidity pool probably is an outlier, some of this stuff really, really needs fixing. And do we think that under Basel III there will be more accounting dodges that will cross the line from ‘asset sweating’ to ‘accounting manipulation’? Not Basel III’s fault, but I rather think we do expect exactly that.

Regulatory risk weightings are still a mess, with the ratings agencies still ensconced as the arbiters of credit quality.

Then of course there is shadow banking, which Basel III largely dances around. One particularly glaring example is the whole custody/client money/asset segregation/rehypothecation/title mess in London. There’s not a peep, burble or whisper here in the UK about the sort of legal reforms (somewhat in the manner of the US’s 1934 Securities Act, perhaps, plus a UK version of SIPC) that would sort this out. Recent Lehman-related rulings on Client Money actually mess the situation up even more. Of course, our obligingly vague 17th century line on “who owns what” works very capital-efficiently for Prime Brokerages. Which is a big part of why Mayfair now houses a $4 Trillion shadow banking system. Push from Basel III would have helped get more of a grip.

I have nothing to say about enforcement; it’s been such a long time since I’ve seen any that I’ve forgotten what it is.

So it should not be at all surprising that former Kansas City Fed chief Thomas Hoenig gives a very strongly worded diss to what passes for financial reform in the US. His point of departure was the idea that UBS might decide to move its investment banking operations to the US. Hoenig dismissed that idea because our regulations are too weak and we should not be allowing new big players to be in a position to fail on our taxpayer nickel. As Hoenig wrote in the Financial Times:

Some argue that both the US Dodd-Frank Act and Basel III capital requirements have now ended US bail-outs. But these efforts do not solve the fundamental flaw in the system: there are highly complex and opaque banking organisations engaged in a variety of non-core, high-risk activities while backed by a public safety net. The problem is not that banks take risk, but that some are too complex for anyone to assess and control that risk.

These new regulatory changes actually extend, or make more complicated, what we have tried to do before. For example, Dodd-Frank requires enhanced prudential supervision and regulation that increases incrementally with the systemic risk of the largest financial companies. Yet that design simply cannot be effective if the risk cannot be monitored or assessed.

Similarly, the new Financial Stability Oversight Council is to look for evolving systemic risk and take appropriate actions – an impossible task because problems are only obvious after the fact. There are many examples over the past 20 years, but one need look no further than the recent housing bubble. I applaud the Swiss for requiring significantly higher capital ratios, but if that were enough, Swiss authorities would be more interested in having UBS retain its investment banking activities.

Hoenig outlined his own proposal, which is presented in longer form at the Kansas City Fed website. It goes considerably in the direction of prohibition, such as limiting the activities of banks to socially useful activities and restricting the access of shadow banks to wholesale funding markets. One can quibble with the particulars of Hoenig’s proposals, but that is the direction we need to go in if we are to have any hope of preventing another large scale financial crisis.

14 comments

While more capital is nice, it is Hoenig who hits on the real issue: banks are opaque and their risk cannot be monitored and assessed.

As you know, I have advocated current asset and liability-level disclosure for banks and in the shadow banking system. Banks are fighting this tooth and nail as they know that it ends their casino gambling and forces them back to useful activities.

It’s not that I don’t think that it is a good thing that they’re at least getting some exposure, but it seems to me that the problem isn’t really that central bankers don’t have any ideas about how to reform the banking system, (well, maybe Ben doesn’t) but rather that nobody listens to them or acknowledges them when they talk about it. Maybe this is about to change, but it hardly seems likely.

(Though I’ll readily grant that it’s good to see that their ideas are becoming more nuanced and elaborate over time, so the efforts aren’t entirely wasted.)

A question, though: are there any real advantages to allowing risk-weighting? It seems to me mightily suspect that this only became ‘necessary’ in the 1990s, when banks were having trouble realizing “additional growth.”

I know next to nothing about life in a big bank, but it seems to me (based on understanding people) that if the leaders of big banks seriously thought they would *personally* go to jail if their organization overvalued their assets or otherwise put global systems at risk, the behavior would change. It all comes down to aligning personal risk to fisky behavior. There was alot of discussion along these lines early on, but the idea seems to have evaporated somewhere along the line.

There is a very interesting discussion that essentially applies Modigliani-Miller reasoning to bank equity ratios. It concludes that the only reason for banks to prefer debt to equity is because they expect bailouts.

“Yves here” …….and for that we are all so grateful.
I just purchased that domain name- Yveshere.com. When all the chips have fallen and all the dust has settled it would make a great title for your retrospective book on the Matter. The Domain is all yours, gratis of course, whenever you want it.

I believe it is closely linked to the petrodollar system and the derivatives used to farm this depleting capital.

Most of the assets on banks books do not create organic capital now – they are merely consumption sinks that shadow oil consumption.
In 71 there was a final choice – become independent from foregin oil or recycle the oil capital throughout the western world – they choose the easy option of course and perhaps made a strategic calculation to burn the stuff before anybody else could.
Now every time there is a oil shock or a surplus squeeze from the bankers perspective they reduce redundancies in systems and make them more effecient transferees of the remaining surplus.
However every time banks do this organic capital dies.
Now the system needs to be tremendously efficient via leverage to sustain the surplus to the banks.
However efficient systems are not necessarily more productive , it seems the financial organism is stretched to the limit.
It is not unlike a cheetah getting faster and faster to chase faster and faster antelope – the cheetah gains more efficient locomotion but at the cost of redundancy and mass.
Eventually there comes a point when it can no longer defend its prey from Hyenas.
Nature likes mammals to have two eyes and hair – bankers running a theoretical jungle would wish to reduce every animal to a one eyed hairless auto mammal in the interests of efficiency – but what happens when it gets cold and dark ?

Yves, another terrific article. I have one quibble with the quote from the Financial Time article:

“The problem is not that banks take risk, but that some are too complex for anyone to assess and control that risk.”
My sense is that the transactions are complex for only one of two reasons:

1. The transaction is purposefully structured to be opaque ( e.g. the same way some tax dodgers structure multi-tiered entities to disguise their true intent) allowing for more profit extraction.

2. Their investing is more akin to gambling(think CDS’s).Whether it’s a one-off or a multi-transaction situation, the probability of transaction failure is low, but when it occurs it’s catastrophic. Seems to me either way, “bet the farm” risk taking is completely inappropriate for these institutions. It’s easy money until something goes wrong.

The point is- we give them way too much credit when one states that they enter into transactions that are too complex for anyone to assess. Calling those activities complex attributes some level of legitimacy. Their “risk taking” is not risk taking that we think of in the conventional business sense. Recent history shows that it’s nothing more than either a structured misrepresentation-or-just pure gambling.

To me, there’s no place for that type of conduct by institutions that rely upon explicit government support.

Author: Uri Praiss, Attorney at law (Israel, since 1990)
law & Economics lecturer

On 4th June morning I saw on T.V. former S.E.C. Chairman, Arthur Levitt, now “Policy adviser for Goldman” (and, I guess, Hill’s traveler like their new “International Advisor”, Ex-Sen. JSD Att. Judd Gregg. Fly together? Private?)

Levitt discussed the reports Goldman has been subpoenaed by Manhattan District Attorney’s office, 2nd last American White Knight, Cyrus Vance Jr., opening a fresh legal front, after GS subpoenaed recently by N.Y. A.G., Eric Schneiderman, as well. Levitt Said “These Subpoenas Mean Nothing for Goldman.”
Is that legal? He should be indicted too, for allowing this crisis, these bombs’ “securities” trade, that cost $ Trillions, including millions of families losing homes, jobs and hope. I guess if Mary Schapiro or N.Y.A.G asked Levitt, just theoretically, how much Goldman pays for his services, he shall be permitted by Goldman to answer.
S.E.C. was founded as one of the most important lessons of The Great Depression .We forgot the other most important lesson – Total Separation between Banks, Trade so called “Investment”, Consultancy, IPOs, etc. Even basic New York Martin Act, 1921 was almost forgotten.
The S.E.C. was created, as a rearmed special force, to defend us against the Robber Barons, or Huns, after they caused, stretched for 6 years and used that horrible national disaster, caused by financial crisis (and Manipulative panic / pessimist Short Selling, but not advanced like nowadays’ Algorithmic “Nuclear” HFTs)
But sooner than later they found out the handsome Huns’ generous attitude (like the wolf after swallowing Red Riding Hood’s Granny) as Mr. Levitt, not to mention the Exchanges, orthodox and modern biased scholars, “experts”, bankers, conservative politicians and officials, research budgets, presentations, conservative parties and rich contributors.
So the Exchanges and S.E.C. went to sleep many years before 2007, allowing the Huns to create and traffic those bombs or drugs “securities”, “Big Short”, “Regular daily shorts”, you name it. Look the other way. Tell the S.E.C. and Exchanges “Liquidity, bigger trade volume, market diversification”, count the fees, etc.

So the S.E.C.’s Investigations focus mostly on “Fishing under the Lamppost”, that gossipy piping Insider Trade Offences, by big billionare Rajaratnam or even this miserable Nelson Obus, hunted for 10 years (and 2 obsessive appeals) because of that “Investi-Mad-Dog”.
By the way, did you know that “Insider Trading” offences were pushed and demonized by Wall Street’s Traders and Analysts’ Lobbyist Cartels? That is not even theft, just populist over – reaction. There is no victim except some righteous vague envy.
In most civilized Securities (Non U.S.) Laws, Manipulations, Fraud, Attempt of Affecting Rates by Short and /or concerted / HFT “Selling Efforts” are much “heavier” offences than famous and juicy “Insider Trade”. The Anti – social and economic damages as well as risks (!!) are much heavier. So is the “Mens Rea” and the punishment is more severe.

“The Report concludes that the most immediate cause of the financial crisis was the July 2007 mass ratings downgrades by Moody’s and Standard & Poor’s that exposed the risky nature of mortgage-related investments that, just months before, the same firms had deemed to be as safe as Treasury bills. The result was a collapse in the value of mortgage related securities that devastated investors. Internal emails show that credit rating agency personnel knew their ratings would not “hold” and delayed imposing tougher ratings criteria to “massage the … numbers to preserve market share.” Even after they finally adjusted their risk models to reflect the higher risk mortgages being issued, the firms often failed to apply the revised models to existing securities, and helped investment banks rush risky investments to market before tougher rating criteria took effect. They also continued to pull in lucrative fees of up to $135,000 to rate a mortgage backed security and up to $750,000 to rate a collateralized debt obligation (CDO) – fees that might have been lost if they angered issuers by providing lower ratings. The mass rating downgrades they finally initiated were not an effort to come clean, but were necessitated by skyrocketing mortgage delinquencies and securities plummeting in value. In the end, over 90% of the AAA ratings given to mortgage-backed securities in 2006 and 2007 were downgraded to junk status, including 75 out of 75 AAA-rated Long Beach securities issued in 2006. When sound credit ratings conflicted with collecting profitable fees, credit rating agencies chose the fees.”

Sorry, but the very bad news and the unhappy end (for now) is that neither S.E.C. nor Robber Barons haven’t learned anything yet. Vice Versa, the Huns have already found, use (on a daily basis) and develop their new “nuclear” arms, at least a year. Almost all financial and real markets, firms and households suffer daily doldrums, stagnation, waste and loss of potential growth and employment.

These are caused mainly by manipulative advanced Hi-Tech and Algorithmic HFT daily trade (by whatever “machines”?!), including Short selling, combined with endless fearful, false and as if professional daily negative economic excuses (Greece’s Debts? Portugal?) Not to mention serial scary “Flash Crashes” S.E.C. and Exchanges don’t want to see.

How they do it? As any illegal anti-trust cartel, the leaders are the most technologically advanced and biggest HFT’s Algorithmic traders (guess who). They are followed by many smaller traders, as Hedge Funds and other big brokers (remember “Huddles”?) that try their best to follow the leaders as fast as they can on real time trade.

Of course the leaders sell highest, and buy later at the lowest rates. That is trivial, because they have a constant “First mover Advantage” and they are much faster technologically. That is why GS, JPM, and sometime others, can make easily $ 100 Million net trade daily profit each. It is reported by financial media. The followers can have some nice profit too. Hedge funds, for example, as smaller traders. Just follow and be alert.

The leaders hit down, to the closest 50 or 100 points line of Dow Jones, as 11,950 and so on and Nasdaq as well – 2,650, etc.
They try to cause fastest down drop, adapting to real time volume. It is almost like driving or skiing. The computer calculates easily which are the stocks, on real time, depend by their specific volume and $ price, that manipulate the whole Dow Jones or Nasdaq (sometimes S&P, to drop or maintain the drop to 1,300, 1,250 etc.)

The regular technical (“natural”) rules of resistance and support do not work anymore. Only the Huns’ HFT Manipulation counts.
So check which stocks can be used most effectively for this daily Dow and Nasdaq Manipulation: GOOG, AAPL, INTC, CSCO, BIDU, etc. Even the trading banks’ shares themselves might be manipulated, depends on volumes and rates.

Europe has already decided to start separating “investment” trade from banking, limiting Short trade and other advanced manipulations. Goldman’s and others’ “agents” try to stop these important suggestions there. But here, S.E.C. and Exchanges, as before, left the doors open, let the Robbers in and went to sleep on the beach. Send Mary to be some Judge, fast as you can. Good night.

Good post, as always. You might want to consider the arguments Perry Mehrling makes about/against the Hoenig proposal. Here’s the key point from Mehrling:

The important point is that, to the extent the market-centered credit system is here to stay, the institutions that support the liquidity of that market system are also here to stay. Even more, to that extent we should view those institutions as essential to the operation of our credit system. The problem is not, as KC would have it, how to keep those institutions out of the safety net but rather how to bring them in explicitly, along with a reformed system of regulation and supervision that ensures their safety and soundness.